UK’s punitive death duty regime is among the harshest in world

Reform is overdue to a system that is both unfair and inefficient, writes Lauren Almeida

Inheritance tax is fast becoming a worry for middle- class homeowners and parents in Britain. And this should worry the Conservatives. Analysis reveals that Britain’s increasingly punitive death duty is amongst the highest in the Western world and is stinging the wrong people.

Increasing numbers of ordinary grieving families are being dragged into handing over tens of thousands of pounds, and the figures show that the ultra wealthy are getting away with paying much lower rates.

A frozen tax- free allowance, an eye-wateringly high rate and a dizzying list of loopholes (known inside out by advisers to the super-rich) mean that it is Britain’s middle classes who pay the price of our broken inheritance tax system.

Reform is desperately needed, experts say, but so far calls for change have largely been ignored.

From a public finance perspective, inheritance tax does not net the Government much money, and so Rishi

Sunak, the Prime Minister, is under increasing pressure to cut the tax ahead of the next election.

Meanwhile, Labour is understood to be plotting to raise the tax even further. It means the wealth of hundreds of thousands of families could be at stake when Britain next goes to the polls.

Everyone gets a “nil- rate band” of £325,000, which is free of inheritance tax. If your estate – which counts your property, your cash, your investments and all your other assets – is lower than this when you die, no tax is due. There is an additional allowance of £175,000 if you leave your main home to your direct descendants, which is known as the “residence nil-rate band”.

Once your money surpasses these limits, the Government can tax you at a rate of 40pc – much higher than elsewhere in Europe, where inheritance tax often does not exist at all, and certainly no match for the United States, where an American “estate tax” only applies to portfolios worth more than $12.9m (£10.3m).

These may sound like big numbers, but the truth is the British tax is hitting thousands more families each year who have accrued wealth simply by being homeowners. The nil- rate band has been frozen since 2009, stuck well below inflation and soaring house prices. It means that the HM Revenue and Customs is raking in more in death duties than ever before: the taxman cashed in £7.1bn in inheritance tax in 2022- 23, up £1bn compared with the previous year. And this figure is going to rise as the Government has decided to freeze tax thresholds until 2027- 28. It expects to net a further £1bn in death duties that families would not have been liable to pay if the bands had been uprated with inflation.

Stuart Adam, of the Institute for Fiscal Studies, a think tank, said: “We are on course to have the most people paying inheritance tax since the 1970s.

“About 6pc of estates are liable for inheritance tax now, but this is going to rise, and inheritance tax is becoming increasingly unpopular. Even people who are not affected by it believe that it is fundamentally unfair.”

It is little wonder that public approval is so low – the figures show that despite the fact that the inheritance tax rate is so high, it is not particularly efficient, and largely does not apply to the super rich. While well-off families with assets worth more than £1m pay an effective rate of 20pc on their wealth, once this hits £9m it drops off dramatically.

Dan Neidle, of the research firm Tax Policy Associates, credits this steep fall to the long list of inheritance tax exemptions, which riddles the whole system with inefficiencies.

“The inheritance tax rate is high for middle- class people, but the tax is so full of holes that it is low for the very wealthy,” he said.

Take the seven-year rule on “potentially exempt transfers”. This allows people to make gifts of an unlimited value, as long as they survive for seven years – a time frame that experts agree is completely arbitrary.

For families whose wealth is tied up in their home, the rule is of limited use. But for a very wealthy person with a £3m house and £7m in cash and investments, they can give away vast sums with little impact on their daily life.

Or, this very wealthy person could decide to move their investments to London’s junior stock market, Aim. These are mostly small companies, so it would be a much riskier place to invest your money – but you only have to hold Aim shares for two years to be free of an inheritance levy.

Then there is business and agricultural property relief. This works well for small, family run operations – without it, a shop or farm worth £500,000 could be hit with a bill as big as £200,000. But other companies could manage this by taking out a loan or asking investors for more money – for less powerful families, this is much more difficult. Most countries therefore have an inheritance or estate tax with special exemptions for private business. But in Britain this arguably goes much further – the exemption has no limit, which means that all businesses, no matter their size, can receive the same special treatment.

It means, Mr Neidle argues, that overall we have a “toxic combination” of a high tax rate, which makes it unpopular and drives avoidance, and a mess of exemptions.

‘Inheritance tax is high for middle-class people, but it is so full of holes it is low for the very wealthy’

Britain is one of the few countries in the Western world with such a punishing inheritance tax – there is no such tax in Australia, Canada or New Zealand, and where it exists in Europe, it is usually at a much lower rate.

In the US, no one is expected to pay any tax on their estate until it hits almost $13m (£10m), which means that a married couple can shield almost $26m. Plus, anyone can give tax-free gifts of up to $17,000 to an unlimited number of people, and it does not count against the larger estate tax exclusion. But international comparisons are not straightforward – how wealthy you are depends on your environment, how much everyone else has, and how much they earn.

At 45 times average earnings, which is around the £1.4m mark in Britain, the effective inheritance tax rate quickly shoots up to become one of the highest in the world.

There seems to be little political motivation to remedy this, even though experts have long called for an overhaul of inheritance tax to make it simpler and more efficient.

Mr Adam added: “There are arguments for and against having an inheritance tax at all. But it is widely agreed that the one we have got at the moment does not work well.

“The proportion of people paying inheritance tax varies over time, but usually bounces around 5pc. When it rises too high above this point, around once a decade, the Government introduces a reform to bring it down again.

“But there are usually longer intervals between these reforms, and we simply do not know when the next one is coming.”

Meanwhile, inheritance tax receipts are piling up at HMRC. In 2020, about 29,000 deaths a year triggered an inheritance tax bill. By 2028, this is expected to rise to more than 47,000.

A dangerous lag in party polls has spurred rumours that the Conservatives could be lining up a big tax- cutting budget before the next general election. Inheritance tax is ripe for the taking – and reports suggest that Mr Sunak is considering lowering the headline 40pc rate or increasing the tax-free thresholds.

Both would be a welcome, but long overdue, reprieve for the thousands of families. Yet much more will need to be done to fix Britain’s problem with this unfair and inefficient tax.